Economics

Bubbles

Turning gold into dross

WHILE equity and bond markets have remained relatively sanguine regarding the impasse in negotiations on America's debt ceiling, gold nevertheless achieved another (nominal) high today, at $1,622. That's one more milestone in an extraordinary run that began over a decade ago. As of Monday, gold's 10-year annualised real return was 16.8%. By comparison, American stocks managed a return of just 14.8% during the 1990s, in a roaring bull market.

Those kind of numbers are naturally prompting some debate concerning whether or not gold is in a bubble. While identifying bubbles is often challenging, gold is particularly tricky as it produces no cashflows and therefore has no intrinsic value.

What gold lacks in fundamental metrics, however, it makes up for with a lengthy record of historical prices, which are helpful in attacking the bubble question. For example, bullion dealer Kitco provides annual prices beginning in 1833. Adjusting the series for inflation, you come up with a long-term average price for gold of $483 per ounce—less than a third of its current price.

Presented with this evidence, goldbugs generally object that the historical average is irrelevant because:

During most of this time period, the price of gold in dollars was fixed.

What appears like a high price for gold simply reflects the debasement of the dollar and the expectation of more of the same. Indeed, even Warren Buffett has warned that officials will be tempted to address America's massive debt by printing money and inflating the problem away.

It's possible to address both of those points by:

Restricting our analysis to the post-Bretton Woods era, in which the price of gold has been allowed to float freely against the dollar.

Extending the analysis to currencies backed by a sound balance sheet, such as the Australian dollar, the Canadian loonie, the South African rand and the Swiss franc (see table at top right).

(Note that, at 84%, Canada's gross government debt-to-GDP ratio is roughly equal to that of the euro zone, and not much better than America's. However, that figure overstates its indebtedness; its net debt ratio is significantly lower, at just 35%.)

The following table summarises the results of my analysis, which is based on average monthly prices, beginning in 1971:

The numbers above suggest that gold's rise in dollars is partially attributable to the shabby state of America's balance sheet, but that simply isn't enough to explain all of it. Using the Swiss franc as a reference currency is particularly instructive, since, like gold, it is considered a safe haven during periods of political or economic risk. Indeed, as was remarked on this website last week:

...the Swiss franc has reached a record in real trade-weighted terms (ie, against the country's trading partners). The Swiss have both a fiscal and a current-account surplus, a low inflation rate and a relatively low debt-to-GDP ratio.

Even against the Swiss franc, gold is overpriced by nearly 60%.

Jeremy Grantham, the chief investment strategist for asset manager GMO and an experienced bubble watcher, defines a bubble as asset prices two standard deviations above the long-term trend (for a normal distribution, that represents roughly the top 2% of values). On that basis, gold is in a bubble in terms of American and Canadian dollars and the South African rand, and is getting close in terms of the Australian dollar.

The only solace the data provides for gold bulls is that we are still some ways from the excesses of the last gold bubble, which culminated in January 1980, during which month frenzied buying lifted the price of gold by two-thirds in only three weeks to $850. That remains the all-time high in real terms, equivalent to roughly $2,470 today.

Less than 10 days earlier, on January 12th, 1980, The Economist ran an article on gold that concluded:

In equity markets, there is much truth to the saying never sell on a strike. In the gold market, which has become in some ways the reverse image of equities, a suitable variant might be never buy on the end of the world. You cannot, after all, take it with you.

Another thing you can't take with you is unrealised gains. Investors who are sitting on such gains on their gold positions would do well to remember this before the current bubble deflates.

The flaw in your analysis is that even structurally sound currencies like CHF, AUD, and CAD are gradually debased over time. This is because of modern central bankers' belief that a little inflation is always a good thing.

My parents bought a nice house in California in the mid-70's for 600 ounces of gold. 35 years later I bought a nice house in California for 600 ounces of gold. That's not a bubble; that's sound money.

"Please do not use gold prices in 1980 in your data series. The price ran up due to the Hunt brothers' ill fated attempt to corner the silver market. It was a very short term aberration and has no economic significance."

If you remove 1980 prices from the data series, the bubble argument becomes stronger since those prices were above the long-term average i.e., Once you remove the prices, the premium between current prices and the long-term average increases.

Firstly,
"Presented with this evidence, goldbugs generally object that the historical average is irrelevant because: ...
2.What appears like a high price for gold simply reflects the debasement of the dollar and the expectation of more of the same."

If the dollar is being debased, it would show up in consumer prices and other asset prices. Inflation adjustment would take care of the first, and the writer has clearly forgotten that he's done this!
As for other assets, well what about TIPS as a safe, liquid asset that is protected against USD debasement? A quick look shows that gold has risen 250% deflated by TIPS since 2006. Is it possible the dollar been debased in such a way that it has halved in value while inflation has been subdued? How else can we observe this invisible debasement? Er...gold?
I see lots of defensive comments here and a lot of imaginative justification of supersticious investment. Gold is a bubble!
Get out before everyone else tries.

I forget who did the analysis but a recent look at gold supply, gold use for jewelry and thus gold available to be held for investment, suggests that the price can be moved a great deal - literally doubled - by a relatively small investment. This marks a bubble in pricing. This is separate from the idea of gold of as a hedge against the value of currency. The amount of money required to double the price of gold has simply not been enough. This also reveals a fundamental problem with thinking of gold as "money".

"My parents bought a nice house in California in the mid-70's for 600 ounces of gold. 35 years later I bought a nice house in California for 600 ounces of gold. That's not a bubble; that's sound money."

My argument relies on -- and the long-term data supports -- the notion that gold is a store of value (again, over the VERY long term only). Unfortunately, that doesn't stop today's prices from being far above that value.

W.C. Varones is right. AD’s analysis is seriously flawed. Gold is up against the Swiss because they have devalued their currency, too, just not as much as the Fed has destroyed the dollar.

It’s not gold that is in a bubble; it’s the dollar. The only way gold will fall in price is if the number of dollars the Fed has spewed into the reality from nothing fall.

The bubble in gold in the 80’s was a real bubble, but it happened because Americans were forbidden by the state from owning gold until then. It took a while for the market to figure out a good price.

Using an historical average for gold made sense in the 19th century when a gold standard would force the money stock to contract sharply after a period of massive credit expansion. The money stock would revert to a mean, so gold would follow.

But since 1973 there has been nothing to cause the money stock or credit to contract even a tiny bit. So the volume of paper dollars and credit dollars continues to pile higher and higher. If you can see the stock of US dollars reverting to its mean of the past 30 years, then it’s possible to see the price of gold doing the same thing.

"If the dollar is being debased, it would show up in consumer prices and other asset prices. Inflation adjustment would take care of the first, and the writer has clearly forgotten that he's done this!"

This is one of the things I don't understand about goldbugs. They are constantly referring to the growth in the money supply/ monetary base, instead of simply looking at the directly measurable debasement created by inflation.

Perhaps it is that many goldbugs appear to believe that the CPI figures are sham, a product of the government's manipulation in order to understate inflation...

NotAGenius, I did a quick polynomial regression on the gold data using the Inverse column as the predictor and it fit better than his model. The regression explained 87% of the variation in gold prices. Very nice indeed!

I'd also argue though that gold may have been undervalued for much of the last 40 years because people had faith in Greenspan and fiat currency. That faith was badly misplaced, obviously. Asset allocation was near 0% to gold during the Greenspan years, and people are just now returning to gold as a store of value.

One thing to consider with gold is the difference between the gold-backed currencies of the past and gold as it is today. In the past, the dollar and other currencies may have been backed by gold, but because of fractional reserve banking, a single dollar's worth of gold could effectively back multiple dollars in circulation (note: this has nothing to do with whether or not the central monetary authority has enough gold to back every unit of physical currency issued). As a result, a person could equate a dollar with an equivalent amount of gold, even though the reality was that there was not enough gold to back every dollar.

In contrast, since today gold is no longer used as currency in a fractional reserve system, those wishing to hold a given amount of the metal generally have to acquire that much bullion. This effectively reduces the supply relative to the past, and so may partially explain the increase in gold's price.

That said, I think a gold backed currency is a terrible way to run an economy. The money supply is far too important to the health of the economy to be left to the happenings of the mining industry. If goldbugs want to bet their money in a side game they play with other goldbugs, they're welcome to it. I want no part in it though.

PS, following AD’s use of net present value to determine the intrinsic value of stocks, you can do something similar with gold. Estimate the future growth in the stock of dollars and subtract the growth in the stock of gold. Discount the difference at the risk-free rate and you’ll have the current NPV of gold.

agile legs: “If the dollar is being debased, it would show up in consumer prices and other asset prices.”

That’s typical of simplistic monetary theory. The biggest mistake people make in monetary theory is ignoring the quantity theory of money. The second biggest mistake is viewing it as working mechanically: the money supply increases so prices increase instantly and in exact proportion.

If the money stock were fixed, prices would decline at the rate of the increase in production. If the money stock grows at the rate of the increase in production, prices don’t change. Prices rise only if the money stock grows faster than the increase in production.

So if the rate of production increases rapidly due to better technology, the rapid increase in output will hide the rapid increase in the money stock for those who only look at prices. Also, the money stock might grow rapidly in a depression, as it has recently, and not raise prices because of idle resources and excess supplies. Finally, cpi inflation measures increases in consumer prices and excludes assets. Much of the increase in money shows up in rising asset prices, such as housing , oil and the stock market.

Gold doesn’t react quickly to dollar depreciation as other commodities like oil and food do. But it’s a good long term measure of the value of the dollar. Much of the rapid rise in gold prices over the past decade is the result of central banks leasing their gold throughout the 1990’s. That held the price of gold down. Now that central banks are net buyers the price of gold is making up for the lost decade of the 1990’s.

Please do not use gold prices in 1980 in your data series. The price ran up due to the Hunt brothers' ill fated attempt to corner the silver market. It was a very short term aberration and has no economic significance.
The run up in asset values (real estate excepted) is due to the US FRB printing money to resuscitate underwater banks.

While central banks and other investors may be diversifying out of the USD and into Loonies, Swissies and Aussies, as well as gold, most retail investors (especially the well to do in Asia) prefer gold both for cultural reasons and because the margins on gold may appear more attractive to a retail investor than retail forex.

Evidence of this includes that the GLD EFT is the most popular of those funds and has been a big recent buyer of gold.